The Granite State’s public pension plan is in the red. Will taxpayers be left to dig the fund out of its $2 billion hole?

Some stories about politics and government are easy to grasp. The facts and colorful characters hit the reader like a cream pie to the face. Other stories are more inscrutable. This is such a story. It is about a stalwart state government agency, shrouded in gray flannel probity, whose communication with the public is about as straightforward as the enigma code. While the tale about the questionable financial condition of the New Hampshire Retirement System pension fund has remained below the radar of the state’s mainstream media, decisions being made today by both the fund and New Hampshire Legislature will financially impact thousands of us in years to come.

a $2 billion I.O.U.
The 108-page Comprehensive Annual Financial Report of the New Hampshire Retirement System is hardly an easy read. But for some, its mid-year release is an anticipated event. Stephen Church, an investment advisor who runs Piscataqua Research, Inc. in Portsmouth, started his professional career as an actuary. First as a health care actuary, then as a pension fund analyst at Wilshire Consulting, for years Church analyzed the financial viability and performance of state pension funds, and he still makes a point to flip through the NHRS annual report. In reviewing the 2005 report published in July 2006, Church honed in on financial data illustrating that the fund continued to remain “under-funded” for the fourth year in a row and that its assets-to-liabilities ratio, or funding ratio, had deteriorated to 66 percent in 2005.

With an asset deficit of approximately $2 billion dollars—the gap between money in the fund and benefits promised to current and future retirees—Church knew this could mean New Hampshire communities and their taxpayers might be asked to eliminate this deficit through higher taxes and a reduction in benefits to future state retirees. Given this possibility, Church was surprised that no one was reporting the story, especially given recently reported troubles of several high profile public retirement funds around the country.

The most well known of these failures was the collapse of the San Diego city pension fund. Through a series of gross managerial errors and thoroughly unstrategic decisions, the San Diego pension fund developed a deficit of $1.7 billion dollars, a deficit slightly smaller than the NHRS fund. When a law requiring the city to alleviate the pension deficit was triggered in 2004, the city found that it could not raise the money it needed because the under-funded pension had led to a downgrade in the city’s credit rating. In repaying hundreds of millions of dollars to the pension fund over the past two years, San Diego’s operating budget has been gutted, basic services have been cut and political calamity and scandal have dominated the headlines. 

Then, a few months ago, the New York Times began a front page series on how poor decisions and inaction of state and local governments have left taxpayers with large unpaid bills for public employee pensions. The series cited numerous examples of weakening public retirement funds in Oregon, Colorado, New Jersey and Illinois. Though not mentioned by name, the NHRS story fit right into the series narrative. It’s this narrative that concerns Church. “By putting off dealing with this issue now,” he says, “the problem will only get worse, and five years down the road, whoever is left dealing with the issue is not going to be happy.”

Which leads to the question less obvious than it sounds: how big is the NHRS $2 billion shortfall? Can the NHRS resolve this problem with little added burden to New Hampshire taxpayers or public employees?  Or will the fund’s current position ultimately lead to a solution best characterized by the graphic financial term as a “cramdown,” where the stakeholders of the state retirement system will be forced to accept highly undesirable terms, such as considerably higher taxes or less retiree benefits?

N.H. track record bolsters current credit rating
Despite its pension fund deficit, the state is in good financial shape, according to Wall Street analyst Nicole Johnson.
Johnson analyzes New Hampshire for Moody’s, one of several highly regarded credit agencies used by Wall Street to analyze state credit risk. She says the state came through the last recession quite well and its financial outlook is stable. She adds that the financial condition of the state pension is only one of many variables that impact New Hampshire’s credit rating, which is currently a very good Aa2. However, she did note that while it’s not uncommon today for state pensions to be under-funded, the NHRS deficit was “higher than normal” and that, though the fund was meeting its obligations to current retirees, its deficit “would have to be addressed.”

The NHRS pension fund, which is governed by a 13-member board, is not unlike an individual’s private savings plan for retirement. Some of the money in the account comes from contributions and some comes from returns on investments. In the case of the NHRS, the contributions come from several sources, and benefits for each retiree are defined when the worker joins the plan. In fiscal year 2005, the funding sources for NHRS benefits included $145.7 million from employee contributions, $133.1 million from employer (i.e., municipal) contributions and $413.7 million in investment gain. 

At present, the NHRS has approximately 51,000 contributing members and is funding benefits for approximately 20,000 former firefighters, teachers, state and municipal employees and police. Employees contribute a percent of their salary, an amount that’s set by the Legislature as required.

Interest income is projected assuming a targeted investment rate, which is currently 9 percent (the assumed rate will drop to 8.5 percent next year).

Employer contributions are determined by the fund’s consulting actuary, who calculates the future benefit requirements and expenses using complex mathematical formulas that include such things as the projected number of covered employees and mortality rates. For the NHRS, this valuation occurs every two years, and employer contribution rates have been estimated through 2009.

As of the end of fiscal year 2005, the funds’ assets (market value) equaled $3.989 billion and its current and future liabilities equaled $5.991 billion. A plan is considered to be fully funded when contributions plus investments equals the plan’s committed benefits and expenses. Though the NHRS is under-funded by $2 billion based on the projections, the plan is meeting its current obligations and, at present, is not in financial trouble.

Stephen Church remembers how throughout the 1990s, New Hampshire had the reputation among industry experts as one of the best-run state pensions in the nation. With record-breaking returns on financial investments, the NHRS was over-funded for most of the decade. In 2000, the NHRS was over-funded by 107 percent. And then came the recession of 2001 and 2002, during which the stock market lost over 40 percent of its value.

One of the premier reports on state pensions, the “2006 Wilshire Report on State Retirement Systems,” analyzed the financial health of 125 public retirement systems over the last five years and found that, across the board, “funding ratios fell dramatically between 2000 and 2003, from 112 percent (average) to 86 percent.” The NHRS, one of the funds included in the report, saw its funding ratio drop to 67 percent in 2003, rise slightly to 72 percent in 2004, but fall again to 66 percent in 2005, a position that places it in the bottom quartile of funded pension ratios included in the report. (The highest quartile consists of the funds with funding ratios of 100 percent or greater.)

The Wilshire Report underscores two points important to an analysis of the current state of the NHRS: first, it is common now for a state pension fund to be under-funded, and second, the NHRS asset deficit is greater than average.

Outgoing state treasurer Michael Ablowich is an ex-officio member on the NHRS board of trustees. While he’s of the opinion that the NHRS fund deficit is a concern, he said that its under-funded ratio “falls somewhere in the middle of the pack,” meaning there are other states experiencing far worse problems than New Hampshire. He also added that the N.H. pension system has been extremely disciplined in fulfilling all of its current benefit obligations. 

Though state law does not require the fund to be fully funded, Ablowich explains there is a state tradition requiring employers to always contribute to the fund. This demonstrates to the national credit markets New Hampshire’s intent to make good on its obligations. He did add, though, that the fact there is a fund deficit “raises another set of questions.”

measuring progress
So how does the state pension fund intend to eradicate its $2 billion dollar gap? Given the opaque nature of its 2005 annual report, questions were directed to NHRS executive director Robert Leggett. However, NHRS would only respond through its public information officer, Kimberly France. Questions were submitted and answered in writing. When asked to identify a specific plan to achieve a fully funded status and when this was expected to occur, France responded:

NHRS is governed by statute, specifically NH RSA 100-A. Pursuant to statutory provisions, the NHRS Board of Trustees, as the fiduciary of the System, oversees the trust fund to ensure that the assets are managed properly. The Board exercises its fiduciary responsibility in part by reviewing and acting upon a biennial actuarial valuation. NHRS’ consulting actuary performs a biennial actuarial valuation to determine the amount of funds needed to pay for future benefits. The actuary considers many variables such as the value of trust fund assets, the number of active members (members contributing to NHRS), the number of members in receipt of benefits, salary amounts, life expectancy, and other variables. The actuary then makes projections of such variables (what those amounts and numbers are likely to be in the future) to determine how much NHRS will need to fund future benefits, referred to as “benefit obligations” or “pension liabilities.”

The Board hires professional investment consultants to manage the funds, operating under a prudent investor rule which encompasses a diversified portfolio to minimize risk. The NHRS general investment consultant conducted an asset liability modeling study to review and develop an asset allocation designed to enable the System to meet it long term obligations. The System’s trust fund assets are valued at more than $4.7 billion dollars.

This $4.7 billion asset number includes amounts in the Special Account and medical subsidy account, which are further explained below.

When asked if the 215-word statement answered the question of how and when, Stephen Church’s response is equally careful. “They mean precisely what they said,” he observes. Church explains that pension managers and actuaries parlay in an exacting lingua franca. It is a form of communication that is “methodical and meticulous and very specific to their process.” But, he adds, “the language is not designed to give you a benchmarkable outcome—it is designed to state that everybody is doing everything in the appropriate fashion. There is no accountability for failure.”

In other words, the NHRS responded to a question about specifics and timeframe with a description of their process, whichthey maintain will return the fund to a fully funded status at some unspecified time in the future.

The 2005 NHRS Comprehensive Annual Financial Report does offer one chapter entitled “progress towards board of trustee goal for funded ratios.” On page 70 of the report, the NHRS describes its plan to lower its investment rate assumption from 9 percent to 8.5 percent over time, and extend the period to achieve its funded goal from 20 years to 30 years, while reducing the amount of the goal from 130 percent to just 115 percent of assets over liabilities.

According to the report, the NHRS plan to achieve full funding is to reduce its benchmark for full funding. In its communication with The Wire for this article, the NHRS has made no statement as to when, within its 30-year time frame, full funding is expected to occur. When asked to comment on the NHRS written response, Ablowich said it was important for the public to go back to the fundamentals of personal financial planning.

“You have goals, and given those goals you put aside a certain amount of money that earns a rate of return. You track the account’s progress. If for some reason your investments in the account lose money, you can do two things—either add more money into the account, or change your goals,” he says.




taxpayers get the bill
The option to add more money to the account has already had a significant impact on municipal budgets. From 2003 to 2007, stated employer contribution rates are scheduled to increase by over 40 percent. Once these rate increases are passed on to the communities, they must pay up.

Michael Marsh, a newly elected state representative from Greenland and a member of the Greenland budget committee, says there’s not much towns can do about this. “We view the pension fund contribution as a line item (in our budget) we cannot touch. We have to accept the figure and move on to see if adjustments can be made with other line items,” he says.

In discussing the NHRS funding status and its rate increases to communities over the past few years, Marsh added that it was his experience that on the community level there is little general awareness of the state pension’s funding situation, nor does it appear that community planners have connected the pension deficit with increased contribution requirements from communities.

One community leader who has connected the dots, and who can be described as the Cassandra of the state pension fund situation, is Jim Dannis, a selectman from Milford. A professional investment advisor by training, he has been a very vocal critic of increased contribution requirements for local communities and is an advocate for restructuring the state pension system.

When Dannis became a selectmen last year, he was stunned to learn the degree to which increased contribution payments to the state pension fund will eat into the Milford budget. In an article for the state political blog NH Insider, he wrote,“From 2003 to 2007, Milford’s annual pension costs (town only, not school) will more than double from $220,000 to $480,000. Pension costs are already locked in at 8 percent of every taxpayers’ town tax bill. With these huge mandatory pension bills, it’s a lot harder to pay for roads and other customary services.”

Dannis refers to the increases in employer contribution rates as an additional “stealth bail-out” tax that has been quietly added to a community’s tax burden. In an interview for this article, he explains, “The sharp increase in pension contribution rates over the last several years is proof that the bailout of the state pension fund is underway. For municipalities, the costs are passed on and hidden in local property taxes.”

He then poses a question to the state Legislature and the NHRS. “Why not be open about it and break out a separate ‘pension bail-out bill’ on the tax bills, like the state education tax? At least the taxpayers would know what the bailout is costing them.”

Dannis has decided to use the blogosphere to break through media reticence on this issue. He fears that the public does not know or understand that “with a $2 billion dollar hole in the state pension fund, most of the pain is yet to come—hard decisions need to be made. And if taxpayers are kept in the dark about the pension issue, they won’t be able to stand up for their interests.”

This past week, the issue finally surfaced in the mainstream media. The annual Local Government Center Conference on New Hampshire Local Governments in Manchester featured a session on the state pension system, and in an article dated Nov. 19, the Union Leader reported on the session and discussed issues surrounding the NHRS deficit. The article, however, didn’t mention another point of concern of expressed by both Stephen Church and Dannis that could potentially worsen the outlook.

The NHRS assumption is that they will receive a 9 percent return on their investments. That assumption is scheduled to drop to 8.5 percent effective July 2007. Corporate pension funds, which are required by the IRS to assume more conservative interest rates, currently use assumptions in the 6 to 7 percent range. The 2006 Wilshire Report suggests 7.7 percent as a realistic investment rate assumption for public pension funds.

In using a higher, more aggressive interest rate, the NHRS may be overestimating its future assets and underestimating its future liabilities, which implies that an already negative situation is actually worse. Dannis is concerned that “in all likelihood, the financial hole is larger than $2 billion.” In a “back of an envelope” calculation using a more conservative interest rate, Dannis believes the current shortfall may be closer to $4 billion.

In a written response to the question about its interest rate assumption, the NHRS stated, “According to the investment consultant and actuary, the rate of return represents a reasonable expectation for returns as provided by governing standards and practice.”

State treasurer Ablowich says that the NHRS reviews its assumptions constantly, though “this doesn’t mean they will be changed every day.”

There is one more thing, however, that the public must keep in mind about the fund’s interest rate assumption. As it pertains to reducing the fund’s deficit, the fund’s return on investments is capped at 9.5 percent (9 percent as of July 2007), due to the Special Account and a medical subsidy account created by the Legislature years ago.

All interest earned on the fund’s investments beyond 9.5 percent is put in the Special Account to fund pensioner COLAs and the medical subsidy account. For example, if, in one year, the fund earns 20 percent on its investments, the first 9.5 percent of the earnings will go into the fund’s general account and be applied to its deficit, while the additional 10.5 percent in earnings would go into the Special Account. As a result, even if there are exceptional years of investment return on the horizon, NHRS cannot take advantage of them to reduce its deficit.

To change this rule is problematic, said Ablowich, because the fund’s many “stakeholders” have come to rely on the Special Account. He also noted that the NHRS cannot make these changes. Only a change in state law can amend the pension benefit structure.

The only other way the NHRS can achieve a fully funded status is by reducing its “costs,” commonly known as benefits. 

constructing a dialogue
New Hampshire state law prevents the reduction of benefits already committed to enrolled participants in the fund. But if the fund’s deficit persists, cutting benefits to future plan participants remains a possibility.

While the pension fund is governed by the board of the NHRS, the type and breadth of the benefits offered by the plan are set by the Legislature.

In an ongoing report (last updated October 10, 2006) entitled “Threats to Public Worker Pensions,” the AFL-CIO ranks by state the degree to which retirement benefits of public workers are under threat. The worst level of threat is “direct privatization threat to public employee retirement security.” The report places the NHRS under a lower level of threat, “potential threat through legislative uncertainty or funding shortfall.”

Specifically, the report states that for New Hampshire, “Public pension system is 70 percent funded. SB 385, up for consideration in 2006 Legislative session, would reorganize the NHRS Board of Trustees. Under the bill, the Legislature could drastically lower the statutory level of benefits by manipulating assumption rates and actuarial assumptions, and decision making power would shift from Board to legislature.” At present, SB 385 has been “placed on the table” at the Finance Committee level.

Though an open public debate on any restructuring of the plan has yet to occur, Ablowich notes that a Senate study committee reviewed the Special Account feature of the pension plan during the last Legislative session, and a group of stakeholders will meet to review the issues raised by the committee and seek consensus on possible solutions. Ablowich also offers that the Lynch administration is aware of the current status of the state pension fund. “I believe (the administration) is committed to working with all the stakeholders to come up with ideas to address these issues,” he says.

Whether it be increased taxes or reduced benefits to valued workers such as firefighters and policemen, legitimate solutions to the retirement system’s funding deficit will ignite political controversy. As Jim Dannis points out, “For many elected officials, it’s a political ‘third rail’ to talk openly about increased taxes, pension cutbacks, or both.”

If a group of elected officials or the governor were to openly discuss solutions to this problem, there would be political hell to pay, says Professor Andrew Samwick, an economics professor at Dartmouth who is nationally known for his proposals on reforming the country’s Social Security system. Because of his position on Social Security reform and his academic interest in public policy, Samwick is well acquainted with the heated emotions that swirl around this particular “third rail” of state politics.

Any discussion on raising taxes or cutting entitlements tends to “be pushed down the road” for some other group to handle in the future, he observes. “Since the funding problem is not a crisis, the solution can be put off until tomorrow.”

It will take a very special leader to buck this Popeye Whimpy Burger rule of public funding (“I’ll gladly pay you Tuesday for a hamburger today”). This person or persons, says Samwick, will need to construct a dialogue that will not assign blame and put forward a plan that will insist that all parties “accept a little bit of pain now to avoid much great pain in the future.”

“Unfortunately,” Samwick says, “in today’s political environment, things that should not be political, are.”

He illustrates his point with a hypothetical. “What if Governor Lynch were to go forward with an open, fair proposal to bail out the pension fund? Come the next election, can you imagine the negative political ads? ‘Governor Lynch is raising taxes!’ ‘Governor Lynch has cut policemen from our local forces!’ and so on.”

Under such an assault, questions Samwick, would the media hold the political attackers’ feet to the fire and remind the public why the plan for the bail-out was instituted in the first place?

If and when an open, transparent discussion on state pension deficit occurs, Samwick suggests that New Hampshire citizens remember that the state has, by design, chosen not to have a large tax base.

“If California lets its state pension fall into the red, it can raise additional state income taxes. We don’t have that option. We must be more mindful of budget issues than high tax states.”

When it comes to managing the state pension fund and budget issues in general, he concludes, “as a state with no income or sales tax, we have to make more of an effort—we have to do a better job.”